Audits See Hidden Value In Life Insurance

September 26, 2005
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GRAND RAPIDS — A period of declining interest rates and a maturing secondary market have quietly inflated the value of many older people's life insurance policies.

While that may be good for policyholders, it has spurred a whole new business segment for entrepreneurs.

Still relatively rare in the West Michigan market, the practice is known as life settlements, in which a life insurance policy is sold on the open market. The investor assumes the responsibility of making the premium payments and becomes the recipient of the death benefit.

The life settlement market is now dominated by institutional funds like the industry-leading Coventry First, which has bought $4 billion worth of policies since 1998. Two local people familiar with life settlements are Paul Damon, president of Family Capital Management, and Bill Boersma, principal of Lawson Insurance Services Inc. and insurance consulting firm Opportunity Concepts.

Life settlements emerged from a much more controversial practice known as "viatical settlements" (from the word via, or way), which developed during the AIDS epidemic in the late 1980s and 1990s. Those settlements involved terminally ill patients.

A life settlement is not intended for the terminally ill, which is legally defined as a life expectancy of 24 months or less. A life settlement generally applies to individuals 70 or older with a life expectancy of 2-15 years, Boersma said, although there are a myriad of situations in which a 60-year-old will qualify and an 85-year-old will not. Also, the market generally rejects policies that are less than 2 years old, due to legal concerns.

Neither Damon nor Boersma are in the life settlement business, per se. Damon is a financial adviser with a particular focus on estate and family concerns, in which life insurance often plays a role, and is one of a handful of advisers who has recognized the hidden value in life insurance policies.

Boersma wears two hats: one is through Lawson Insurance Services where he serves the brokerage community with market and underwriting support; the other is as a third-party consultant. Life settlements naturally emerge through his consulting practice, Opportunity Concepts, during policy audits.

Working with insurance agents, attorneys, accountants and trustees, Opportunity Concepts reviews and analyzes life insurance holdings for use in business and estate planning and insurance products marketed under certain tax codes, usually to defer compensation.

This applies in cases where a policy is perhaps 10 years old, and after a decade of falling interest rates may not perform as well as a policy created in today's marketplace.

"It's 'underperforming' the way it was bought," Boersma said. "Does the client understand that? Probably not. Does the adviser? Maybe, maybe not."

Boersma's role is to evaluate if there is a better option available on the market today of which the adviser should be aware. Granted, that is not always the case, but in the current investment market, it often is.

A life settlement comes into play when the client decides to switch policies. Rather than surrendering the original policy for its cash value, Boersma suggests investigating the life settlement market, where the average payout is three to five times higher.

"Sometimes a little more, sometimes spectacularly more," he said. "It's very difficult to make an informed decision without the information we bring to the table."

He explained how one client was a signature away from accepting a $10,000 check to surrender a $1 million policy. The market value proved to be $500,000.

Roughly 25 percent of Boersma's life settlement work is not generated through his audit service. In this situation, the client has determined to cancel a policy regardless of performance. Commonly, these are corporate policies on business owners and top executives that are made obsolete by retirement or the company's sale.

Occasionally, this has dramatically altered the finances of a company or played a role in the buying and selling of companies. Boersma has seen situations where a seller who wasn't getting the expected value for his or her company was able to turn the deal around once the life insurance policy was separated from the deal. He also has seen a buyer acquire a policy on the former owner and sell it for much more than the surrender value.

"The first time someone hears this, they joke, 'I hope someone with an Italian name isn't going to be following me,'" Boersma said. "Someone now has a financial interest in your early demise. But if you look at it, there are an awful lot of people and institutions that have an interest in your early demise: parents who have an annuity, pension plans, all the way down to Medicare and Social Security … (and) children."

Furthermore, Boersma reported national evidence that advisers who do not investigate the full market value of a policy can be held liable for the lost opportunity.

Boersma has been involved in one viatical settlement. In that case, the market produced a $500,000 payout for a young client suffering from a terminal illness who had intended to drop a term policy with no reimbursement.

Through the 1990s, investors noticed that thousands of terminally ill patients were letting their policies lapse because they could no longer afford the premium payments. Patients with a term policy could sell the policy to investors for a lump sum, often as high as 60 percent of the death benefit. Those with a cash-value policy often chose to "viaticate" for payouts exponentially larger than the surrender option.

Patients sold their policies to investors for a variety of reasons, such as to ease the financial burden on themselves and loved ones, to pay medical bills, and to maintain financial independence. But a problem for investors arose when many patients began using viatical settlement funds for advanced medical care, explained Damon.

"Many investors paid quite a premium for these policies because they expected them to die quickly," he said. "A lot of them didn't die, used the money to prolong their life — and those turned into pretty bad deals."

The viatical industry was also plagued with fraud, Ponzi schemes and mismanagement. A local example is current federal inmate Thomas J. Smith's Trade Partners Inc., the Grand Rapids-based firm that dealt in fraudulently issued policies and bankrupted the fund intended to make premium payments. Over 3,400 investors lost a total of more than $200 million.

"There were a lot of shenanigans on the other side of the market," Boersma said. "But that's not the market we want to be talking about; the universe is unanimous in its consent of life settlements … with the lone exception the insurance companies themselves."    

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